Unit 4: Dissolution of Partnership Firm

The dissolution of a partnership firm results in the business being discontinued. Dissolution consists of disposing of assets, clearing payment for liabilities and distributing the profit or loss among all partners.

A firm may be dissolved in the following ways:

1. Dissolution by agreement which can be with the consent of all partners or a contract between all partners.

2. Dissolution, which becomes compulsory when all partners become insolvent or any changes in government policies make the business illegal.

3. Dissolution that is based on certain conditions such as a fixed period, purpose, death of a partner or insolvency of a partner/partners.

4. Dissolution by a written notice given by a partner with the intention to dissolve the firm.

5. Dissolution by a court on account of a partner becoming lunatic, indulging in illegal activities, found guilty of misconduct, incapable of performing duties or dissolution reason found justified.

The following rules are applicable to the settlement of accounts after a firm is dissolute as per Section 48 of the Partnership Act, 1932.

1. Amount which is received on the sale of assets should be used in the following order

i. Paying off all external expenses and liabilities

ii. Loans and advances that are owed to partners should be cleared.

iii. Capitals of all the partners should be paid off.

Any amount that still remains after paying off all these items should be distributed among partners of the dissolute firm in their original profit sharing ratio.

2. In case of loss and capital deficiency, the following should be paid in order:

i. Adjust loss and capital deficiency against profits of firm.

ii. Adjust against the total capital of the firm.

iii. If there exists any loss or deficiencies after all the adjustments, the next course of action will be to bear the loss as per the individual profit-sharing ratio.

When a firm is dissolved, it results in the closing of all accounts, assets are sold off, and liabilities are paid off. To maintain a record of all such activities, a nominal account is prepared, which is called a Realisation Account. Its main purpose is to determine the profit or loss that happens due to settling off assets and liabilities. If this exercise results in profit or loss, it gets transferred to the Partners’ Capital Account with their original profit-sharing ratio.

The main objectives of preparing a realisation account are as follows:

1. To ensure all accounts are closed

2. To record all transactions that are related to sale of assets and paying off liabilities

3. Determining whether profit or loss is happening due to the sale of assets and paying off liabilities.

The format of a realisation account is as follows:

A deficiency of creditors arises when a firm is unable to pay off the creditors after selling all the assets and utilising the partner’s private assets. In such a situation, there are two procedures that need to be followed:

1. Transferring deficiency to Partners’ Capital Account: In this procedure, creditors get paid from the cash available with the firm, which includes each partner’s individual contribution. The deficiency is transferred to the Partner’s capital account and therefore is managed by all partners as per their profit-sharing ratio. In case a partner becomes insolvent, it is regarded as a capital loss for the firm. If the partnership deed has no clause for such a situation, then the capital loss needs to be borne by partners who are in a solvent state and as per their capital ratio in the firm, as per Garner vs. Murray case.

2. Transferring the deficiency to Deficiency Account: In this process, a separate account is prepared for creditors. Then to determine the cash obtained from the sale of the firm’s and partners’ private assets, a cash account is prepared. Then after determining the cash available with the firm, creditors and external liabilities are paid, but not in full. The remaining creditors or the deficiency is then transferred to the deficiency account.